Is this how investors can help replace fossil fuels with green energy? YieldCos aim to pay steady dividends and cut risks

Can investors back clean energy and make a profit? Rather than develop the technologies and projects themselves, 'yieldcos' specialise in buying and operating renewable energy power stations.

Dr. Charles W. Donovan, Director of the Centre for Climate Finance & Investment at Imperial College Business School, explains more about them.

YieldCos are companies that put together a collection of assets that produce green energy

These days, it’s easy for investors to recognise the physical evidence of man-made climate change and observe the technological disruptions playing out in energy markets.

As a result, a growing number of investors are drawing the conclusion that fossil fuels no longer have a place in their portfolios. As 2016 drew to a close, investors controlling roughly $5trillion in financial assets had pledged to divest from fossil fuels.

Yet cutting out the risks from fossil fuels isn’t quite so simple. For most, it’s not an option to cancel one’s exposure to the energy sector. Energy is one of the world’s largest industrial sectors and the price of oil and natural gas has an impact on just about everything consumers buy.

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HOW THIS IS MONEY CAN HELP

So, the question many investors are asking now is, how does clean energy investing stack up against more conventional competitors?

Is now the right time for smart investors to shift from oil and gas to alternatives?

There’s one clear reason why investment in clean energy is attracting more attention these days.

Put simply, renewables have gotten a whole lot cheaper.

According to oil giant BP, wind and solar energy are already cheaper than their fossil-fuel alternatives in many regions around the world, most notably large parts of the US. Such regional phenomenon will become global within the next five to 10 years.

If this sounds bullish, keep in mind BP’s noble admission in this year’s outlook that past forecasts have systemically underestimated the growth of renewable energy in the world economy. Some would say they are still too far behind the curve.

Yet, it’s been a very bumpy ride for investors trying to ride the trend towards cleaner energy. Most of the publicly-listed ‘pure-plays’ in the sector are dedicated to technology development and manufacturing. Overall, these have fared terribly for shareholders.

New model: YeldCos are are a novel way of financing clean energy as they do not hold the risks of development

The major clean energy indices are still languishing well below their peaks before the financial crisis, having endured gut-wrenching price drops.

Academic research undertaken on behalf of Norway’s sovereign wealth fund revealed that the most prominent tracker, the Standard & Poor’s Global Clean Energy Index, has a negative annual return over the eight-year period 2007-2015.

What’s worse, the index has exposed investors to twice as much volatility as more broad market indices. Negative returns and high risk: that’s hardly a good way to build for retirement.

Excitingly, there’s a new breed of clean energy company now out there. First launched in the UK in March 2013 and subsequently copied in North America and Asia, clean energy 'YieldCos' trade on a very different business model.

Rather than develop the technologies and projects themselves, they specialise in buying and operating renewable energy power stations.

Smart investors know that it’s business models, not generic industry designations that matter these days.

Consider a company like Airbnb. As an individual investor, you can’t yet buy its shares. But if you could, who would you compare it to?

Airbnb can be thought of as the world’s largest hotel chain, although it doesn’t own a single bed. But would Hilton Hotels be a good comparator in testing the risk-return proposition of Airbnb shares? Certainly not.

It’s clear from even a cursory glance that the risks of running an internet platform like Airbnb are different to running a real estate empire. So, too, are the financial returns.

While history is not always a reliable guide to the future, it plays an important role in how investors conceptualize risk. More specifically, we know that the distribution of past financial returns shape investors’ expectations of future investment performance.

Like Airbnb’s backers, investors in clean energy YieldCos have been flying blind over the past few years, due to the lack of a historical precedent for their business models.

In Germany, retail investors already own nearly half of renewable energy generation capacity but in the UK, they have so far tended to stick with what they know - oil and gas

How YieldCos work

A YieldCo is formed by transferring operational power generation assets into a newly incorporated company. The YieldCo then distributes the majority of retained earnings to shareholders in the form of dividends.

The model allows investors to gain exposure to a diversified set of operational assets, each backed by long-term contracts for the sale of electricity. Proponents maintain that YieldCos offer the risk profile of a government bond, but with a dividend yield comparable to FTSE heavyweights BP and Royal Dutch Shell. If so, is clean energy finally becoming a safe bet for investors?

Dr Charles Donovan is Director of the Centre for Climate Finance & Investment at Imperial College Business School

Why they are attractive

At the Centre for Climate Finance & Investment at Imperial College Business School, we have been considering the evidence.

We’ve found that a portfolio of UK YieldCos offers superior risk-adjusted returns to a range of indices, including the FTSE 100, FTSE small cap and FTSE oil & gas.

In our analysis, we compared the performance of all six listed UK YieldCos over a three-year period, the maximum period possible with the data series. While the returns on the YieldCo portfolio were generally higher than those of the indices, what really stood out was the level of risk reduction.

Across the board, the standard deviation of returns was substantially lower in the YieldCo portfolio. That’s important because it means that investors achieved average or superior returns, while exposing themselves to less financial risk.

For governments to come anywhere close to their commitments on global warming, trillions of dollars of investment in new clean energy installations will be needed around the world

Now, for governments to come anywhere close to their commitments on global warming, trillions of dollars of investment in new clean energy installations will be needed around the world.

Individual investors hold nearly half of the financial assets worldwide. If the financial proposition is attractive, they can be an important potential source of funding.

In Germany, for example, retail investors already own nearly half of renewable energy generation capacity. In the United Kingdom, individual investors have so far tended to stick with what they know in the energy sector, that means oil and gas.

Verdict

Our ongoing review of clean energy investing indicates that this bias may be set to change. The evidence shows YieldCos to be a straightforward and profitable way for investors to gain exposure to their domestic energy sector.

For an investor seeking income with no currency risk, clean energy YieldCos are bucking the conventional wisdom that there’s a trade-off between profits and the planet. That’s good news for investors of all stripes, not just those concerned about the environment.

YieldCos: What they are and how can you buy them

What are YieldCos?

YieldCos are companies that put together a collection of assets that produce green energy.

These assets could include onshore and offshore windfarms and solar power installations.

Most of the earnings made from producing energy are returned to shareholders in the form of dividends.

They are a novel way of financing clean energy as they do not hold the risks of development – only existing projects are bought up. Funds tend to hold assets in several projects, so risk is diversified.

Why haven’t you heard of them before?

Lots of people don’t understand them yet. They’re lumped with clean energy, which people often see as risky.

YieldCos in the US have also had a turbulent few years, with dramatic share price drops. However these investments had a different structure to those available in the UK.

How many are there?

There are currently six in the UK. The UK innovation was then copied in the US, but the whole thing was sold on a different basis – as growth stocks rather than those returning a steady dividend.

Growth in the share price became unsustainable, because investors didn’t understand what the companies were trying to do. The UK YieldCos are also still relatively small at the moment.

How do you buy them?

You can buy them as you would shares of any other company – through your broker or online as they as listed on the stock exchange. The process is no different to buying shares in BP or Shell.